- Proof of Stake (PoS) is a consensus protocol — or a set of rules or system of agreement — that’s used to validate cryptocurrency transactions.
- PoS redefines how blockchain nodes agree on which record of crypto transactions is accurate and improves upon the Proof of Work (PoW) system.
- PoS requires validators to stake tokens to validate transactions, while PoW requires miners to solve a cryptographic puzzle.
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Proof-of-stake (PoS) is a consensus mechanism for blockchain networks. In PoS, the nodes of the network commit “stakes” of tokens for a set period of time in exchange for a chance at being selected to produce the next block of transactions. The node that’s chosen — referred to as the “validator” — will receive the block rewards in the form of the native token of the network.
How does proof of stake work?
To answer the question “what is proof of stake,” we must first define what it means for blockchains to achieve consensus.
Blockchain is a decentralized distributed ledger of transactions. Because there’s no single server controlling the network, there has to be some way for everyone to agree on which transactions are valid. Otherwise, it would be possible for people to create fake transactions.
The servers in a blockchain are called “nodes.” Nodes process transactions. Some nodes have the ability to add blocks of transactions to the chain, maintaining and growing the ledger. In Proof of Work (PoW) networks (which we’ll cover later) like Bitcoin, these nodes are referred to as “miners.”
For PoS, nodes commit funds to the network — a process known as “staking” — for a chance to be chosen as the next block writer instead of nodes competing with each other to be rewarded for solving cryptographic puzzles, as is the case with PoW.
In PoS networks, nodes that can add blocks are called “validators,” which are individuals who are responsible for verifying transactions on a blockchain. Each validator has a chance at being selected to write the next block and receive its rewards.
It’s kind of like a lottery – the larger the stake of tokens committed, the higher odds that node has of being chosen. “The choice of the next block writer, the next validator, is a pseudo-random process that’s determined by the size of the stake that you as the user have dedicated to the network,” says Daniel Gould, CEO and co-founder of Nodamatics.
PoS can improve upon some of the biggest problems presented by PoW, namely:
- Energy consumption: PoS requires less energy than PoW.
- Transaction throughput: PoS networks can handle more transactions than PoW.
- Scalability: PoS networks can scale more easily than PoW networks.
Which cryptocurrencies use proof of stake?
A growing number of the most popular cryptocurrencies use some variation of the PoS protocol. Here’s a partial list:
- Cosmos (ATOM)
- Cardano (ADA)
- Polkadot (DOT)
- Solana (SOL)
- VeChain (VET)
- Tezos (XTZ)
These networks aim to accomplish a variety of different tasks.
- Cardano and Solana are focused on providing smart contract functionality, much like Ethereum.
- Cosmos helps different blockchain communicate with each other.
- Tezos is designed to allow for the creation and trading of security tokens.
Because there is no “mining” involved in PoS, PoS networks often start with a “pre-mine,” where the entire supply of tokens is brought into existence at once.
Can you make money with proof of stake?
The short answer is yes. Those who become validators have the opportunity to win the next block reward of new tokens for their network of choice. But not just anyone can become a validator.
“You have to have a certain [number] of coins to become a validator that actually moves the chain forward,” says Drew Beaudry, who works in Strategic Partnerships at Tendermint. “Most people can become a validator node if they want, but they won’t actually have votes on moving the chain forward, and they won’t be rewarded for participating.”
The number of tokens needed to become a validator varies according to the network. For some networks, the price could be small, while others could require quite a large sum. Ethereum (ETH), for example, plans to require a stake of 32 ETH for people to become validators once the network transitions from PoW to PoS.
Thankfully, some crypto exchanges have made things easier for retail investors looking to stake their PoS coins.
Rather than having to set up your own validator node, some exchanges have become validators themselves. They then offer to stake tokens on behalf of users who hold PoS tokens in their exchange wallets (in exchange for a hefty fee of the profits). There’s usually no minimum amount required.
Some of the largest exchanges, like Binance and Coinbase, offer staking for various tokens like Cosmos (ATOM), Tezos (XTZ), VeChain (VET), and others. To participate, users simply buy or deposit coins and hold them in their exchange wallet. Staking rewards will then be paid out to that wallet on a regular basis.
However, some have criticized this approach as being too centralized. If big exchanges become the majority of validator nodes for any given proof-of-stake token, then most of the network will be concentrated into the hands of a small oligarchy.
Gould acknowledged this in saying that Nodamatics is “actually doing research on this issue at the moment,” with regard to the geographic and technical diversification of the infrastructure that runs proof-of-stake networks.
Beaudry also noted that the security of a PoS network is primarily tied to two things:
- The value of its token
- The extent to which the token’s supply is decentralized
While PoS coins with market caps in the billions of dollars might not have to worry about the first issue, the second one could become problematic if exchanges wind up hosting too many validator nodes.
Proof of stake vs. proof of work
Both PoS and PoW mechanisms achieve the same end goal, but by different means.
The main difference between networks that use PoS and those that use PoW is how the network achieves consensus for its blockchain.
Gould notes that PoS is easiest to understand “if it’s contrasted to proof-of-work.” He goes on to explain that “in proof-of-work, the consensus is achieved by allowing a single participant to write the next block in the blockchain and be rewarded in the native cryptocurrency of that blockchain for their efforts.”
Miners are effectively spending large amounts of computing power and electricity as they work on “solving a very hard cryptographic puzzle.” This approach has been criticized as requiring too much energy, having difficulty scaling or growing the network, and not providing enough throughput (the ability to process many transactions).
The financial takeaway
Proof of Stake (PoS) is a consensus mechanism used to validate crypto transactions and is meant to improve upon perceived flaws of Bitcoin’s Proof of Work (PoW). Some of the largest and fastest-growing coins have implemented this protocol.
Holders of PoS tokens can earn a “crypto dividend” on their holdings by staking their crypto and becoming network validators. Because this sometimes requires a substantial investment, exchanges have taken it upon themselves to make the process simpler and more affordable for the average user.
Understanding how PoS is key to understanding cryptocurrency and how it works. In general, it’s always better to know what you’re investing in before getting involved.